‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from venture capital investors. Further information about The VC Series can be found here.
This article explores how restrictive covenants work, why they are important to VCs, and the areas that founders should pay particular attention to.
Restrictive covenants are provisions contained in the Investment Agreement that limit the activities of the founder(s) (and potentially other key employee shareholders) both during and after their involvement with the company.
They are often similar to those that you would expect to see in a founder’s service agreement, but in the Investment Agreement (i) are linked to the time of the founder’s shareholding, not just the founder’s employment, and (ii) are more likely to be enforceable, as the founders are giving the covenants in their capacity as a shareholder in consideration for the investment that the VC is making (rather than just as an employee).
When VCs are investing in a company, they are to a large extent backing the founder(s) and the senior management team.
The founder(s) are almost always the repository of much of the key information relating to the company (whether that be market knowledge, its technology, or relationships with customers and suppliers), which from the VCs’ perspective makes it vital that they guard against any negative consequences of the founder(s) ceasing to be involved in the company.
The restrictive covenants typically restrict the founder(s) from the following:
Whilst it is perfectly usual for a founder to be bound by restrictive covenants in this way, it is still important that the right balance is struck.
Key points that are often the subject of negotiation are:
We can help talk you through the consequences of these provisions and make sure that the restrictive covenants that you agree with are as reasonable as possible.
The next article in The VC Series looks at preference shares, the share class that a VC will typically subscribe for.
You can find details of all the different articles in the VC Series here.
If there is anything that we have not covered which you would find useful, then please let us know.